Why Is the Market So Sick?

Leo Kolivakis  |

Fred Imbert, Sam Meredith and Yen Nee Lee of CNBC report, Dow drops 500 points amid rising fears over global growth:

It was another terrible week for stocks, any way you slice it, this market is sick, very sick (and I don't mean that in a good way, like "Sick! Stocks are up again!").

Martin Roberge of Canaccord Genuity summarized it well in his weekly Portfolio Incubator:

My readers need to subscribe to Martin's research to read his reports and notes, and I encourage you to do so.

Anyway, why are the markets so sick? That's what I'll attempt to answer this week in my Friday weekly market comment.

First, there's no doubt trade tensions are starting to take their toll. On Friday, China reported industrial output and retail sales growth for the month of November that missed expectations.

I've been warning my readers all year to pay very close attention to Chinese shares (FXI) as well as emerging markets shares (EEM) which are a barometer of global growth (click on images):

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You'll notice these two charts look similar and that's because China is a major determinant of emerging markets.

You'll also notice the downtrend in shares is intact, you had a recent bounce off the 200-week moving average but that's all it is, a bounce.

There are two negative factors at work here. One is trade tensions but the other more important factor is higher US interest rates, which have sucked global liquidity out of the system, hitting all risk assets, especially emerging markets.

Even emerging markets bonds (EMB) have been hammered this year (click on image):

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The market is telling you something, namely, global growth is slowing and there's a risk the US economy which has hitherto been flying high, is at risk of faltering and joining the rest of world.

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In fact, have a look at US financial stocks (XLF), they are down 20% from their highs and have entered a bear market (click on image):

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If the US economy is doing so well, why aren't bank stocks surging higher? They're telling you something, the economy is decelerating fast.

And the stock market is signaling a slowdown ahead. Randall Forsyth of Barron's recently wrote an article, It's the Stock Market Stupid, where he notes the following:

It remains to be seen if "one and done" is the Fed's new mantra but if you ask me, the damage is already done.

Importantly, forget the circus show in Washington, Brexit, Frexit, trade tensions, the cumulative effect of soon to be nine rate hikes are starting to bite the economy. You see it in housing, the auto sector and other interest rate sensitive sectors.

From a macro perspective, even if the Fed pauses here, the damage is done. The US economy is slowing, the US dollar will stop surging higher in Q1 of next year, and the big wild card is what happens in the rest of the world.

If the Fed pauses, you would expect emerging markets to take off, global growth to pick up, oil and commodity prices to start bolstering and heading higher. This will benefit commodity currencies like the Aussie, loonie and kiwi.

But if global growth doesn't pick up, then 2019 will be the year of a synchronized global downturn, risk assets will languish, and US bonds will outperform all other major asset classes (click on image):

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You'll notice that US long bonds (TLT) are doing well recently which is exactly what you'd expect when the market is selling off.

It's too soon to tell whether or not this trend continues into the new year. There are a lot of moving parts to the market and economy, a lot of risks in the background.

And they're not all financial risks. What if Trump is impeached next year? You will see the US dollar and stock market sell off hard and bonds take off.

Right now, all this uncertainty over the Fed, China, Brexit, Trump, is causing many investors to back off, stop buying the dips and start selling the rips to raise cash.

In fact, Zero Hedge had a comment that one theory behind who's behind the "sell the rip" in the market is global pension funds are selling stocks to invest in bonds and raise cash.

But I can tell you from the senior pension execs in Canada that I've spoken with, they feel much more comfortable buying the dips now that valuations have come down than at the beginning of the year.

And Suzanne Bishopric just sent me an article stating pension funds bought emerging markets as they tumbled (remember, a lot of them need to make their actuarial target rate of return).

Another theory is that CTAs and hedge funds reeling from steep losses are the ones behind all the selling. They're cutting risk all around, cutting headcount too, and selling their winners and losers to just end what's been another horrible year.

I was telling a friend of mine earlier that I don't like these markets at all. Drip, drip, drip lower, then a rip here and there and right back down, drip, drip, drip lower, making new lows.

If you've been around long enough and traded in all sorts of markets, you know these markets and they don't give you that warm fuzzy feeling inside. Quite the opposite, it's what I call the Chinese water torture markets.

For all effective purposes, the year is over. We shall see what the Fed does next week and whether investors will react positively or sell the rip again but either way, I don't expect it will make a difference in terms of annual stock returns.

All I can tell you the contrarian trade next year will be to buy/ overweight cyclical shares like emerging markets (EEM), financials (XLF), industrials (XLI), energy (XLE) and metal and mining shares (XME) and sell/ underweight stable sectors like healthcare (XLV), utilities (XLU), consumer staples (XLP), REITs (IYR) and telecoms (IYZ).

But being a contrarian often lands you in deep trouble, especially in these flash crash markets dominated by high-frequency algos.

I leave you on another note. Earlier this week, I wrote about why CPPIB is shorting small and mid-cap European shares. Jeffrey Snider of Alhambra Investments just wrote a comment, The End of QE Will Always Devolve Into This Sort of Incoherent Mess. Take the time to read it here, he raises many excellent points.

Problems are piling up all over the world, and I haven't even talked about credit markets where investors are now very concerned about leveraged loans.

Being a contrarian in this environment is a leap of faith, it might very well pan out but my advice is stay safe, focus on stable sectors like healthcare (XLV), utilities (XLU), consumer staples (XLP), REITs (IYR) and telecoms (IYZ) and always hedge your equity risk with US long bonds (TLT).

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